13th July 2008
The Malta Independent on Sunday
There’s something
strange going on in the financial world for which there is as yet no definite
explanation. The world had grown accustomed to living smoothly with structural
imbalances without great problems but suddenly something snapped and these
imbalances no longer seem sustainable.
The USA, as the holder of the reserve currency of the world, has been running huge balance of payments deficits, which were being reflected in huge surpluses in oil-exporting countries and in China, Japan, India and other Asian economies. Notwithstanding the huge magnitude of such imbalances they did, for a time, seem to defy the laws of natural economics and appeared sustainable indefinitely without difficulty, as surplus countries accumulated reserve dollars which they gladly re-lent back to the US at cheap rates.
This worked well for the US consumers who could so afford to live beyond their means through easy credit on terms that indicated repayment could only come by taking a larger loan to re-finance. Larger debt was not considered scary, as the availability of cheap credit brought an asset price bubble in real estate making the net finances of consumers appear stronger, higher debt notwithstanding, for as long as the value of their immoveable, mostly residences, kept increasing.
It also worked well for the surplus countries as it permitted them to peg their own currencies to the US dollar in order to protect their price competitiveness by not allowing their own currency to revalue in accordance with the efficiency gains and development of their own economy.
Reality can be avoided for a long time but not forever. Something had to give and it finally snapped on both sides of pacific, and also in Europe, with unpleasant consequences.
On the US side, the property bubble burst with very severe consequences on the US consumers, who are witnessing the value of their property fall below the level of covering mortgages, leading to loan defaults, foreclosure and a glut of unsold property stock that is continuing to depress property prices, sometimes to exaggerated levels. The pendulum never stops in the middle when it is released from far out. This is causing the banks to register huge losses on their property exposure, weakening bank balance sheets, demanding massive recapitalisations and causing severe illiquidity on the financial markets, where even the most deserving are finding it difficult to access credit.
On the Asia side, the fall in the value of the US dollar and the corresponding fall in their own pegged currencies is causing accelerating domestic inflation, overheating their economies with an increased risk of economic collapse and huge foreign exchange losses on their foreign reserves if the rate of exchange of their domestic currency has to be allowed to revalue to mitigate the serious problem of inflation.
On the European side, countries who had experienced a property boom caused by their recent economic successes, such as the UK, Ireland and Spain, are now being hit by the burst property bubble and illiquid financial markets imported from the US. Euro area countries are suffering from an overvalued currency that had to absorb the fall in the value of the US dollar, which should have been absorbed by the surplus Asian currencies that however remain artificially pegged to the US dollar.
Every country is suffering under the severe strain of exploding energy prices and exploding food prices, which was contributed to partly by the mistaken policy of trying to solve the energy crisis by shifting to bio-fuel production the resources normally allocated to food production.
We are now in the painful phase of re-balancing structural imbalances which suddenly became unsustainable. The US economy is slowing, flirting with outright recession at a time when consumers are being hit right, left and centre. Their asset values are falling, their purchasing power is being hit by the doubling of energy prices and they are suffering withdrawal symptoms from credit dependence as credit is no longer available. This slowdown will reduce consumer demand, which will address the balance of payment deficit through rising unemployment and business defaults. Asia will also have to slow down its pace of growth if it is to address its domestic inflation problem. Higher domestic interest will make the currencies of Japan, China, Korea, Taiwan and other Asian tigers unable to sustain their peg to the US$. In the absence of a drastic decision to allow their currencies to float freely, monetary authorities will have at least to tolerate greater flexibility in their peg to the US$. A contemporaneous slowdown in the US and Asia will go a long way to address structural imbalances but only at the expense of a rather prolonged, even if shallow, recession. Such curtailment of demand would then reduce the rise in the price of energy and commodities and sometime in 2009 we could possibly look forward to growth based on a more sustainable base.
There are many theories as to why we have come to this point and why it has happened so suddenly, when until this time last year the world seemed perfectly comfortable with long-standing structural imbalances. My explanation to this is what I term the curse of the reserve currency.
The moment a currency is accepted as an international reserve currency there is born within it the seeds of its own destruction. The owner of the reserve currency, as the US has been since the end of the Nazi war, has the facility to acquire its needs from the rest of the world merely by creating more of the freely acceptable currency. In reality, it becomes an obligation to service world growth by creating more of the reserve currency entailing the reserve currency-owning country to start running chronic balance of payments deficits. In simple layman’s language, this means that the owner of the reserve currency will be duped to start living well beyond its means.
Too much of a good thing gradually starts creating its own problems, as reserve currency holders start getting restless with the large accumulation of reserves and growing doubt about the sustainability of its value. Six years ago the US$ was worth €1.290. Now it is worth €0.58. Its value has more than halved in Euro terms. Could the increase in the price of energy and commodities be explained, at least in part, by the policy of mass holders of US$ to convert them into real assets as quickly as possible by buying energy and commodities both spot and futures before the dollar falls further?
We are possibly at the sunset stage of the US$ as a reserve currency after suffering the curse reserved for such status. What will take its place remains to be seen.
The Malta Independent on Sunday
There’s something
strange going on in the financial world for which there is as yet no definite
explanation. The world had grown accustomed to living smoothly with structural
imbalances without great problems but suddenly something snapped and these
imbalances no longer seem sustainable.The USA, as the holder of the reserve currency of the world, has been running huge balance of payments deficits, which were being reflected in huge surpluses in oil-exporting countries and in China, Japan, India and other Asian economies. Notwithstanding the huge magnitude of such imbalances they did, for a time, seem to defy the laws of natural economics and appeared sustainable indefinitely without difficulty, as surplus countries accumulated reserve dollars which they gladly re-lent back to the US at cheap rates.
This worked well for the US consumers who could so afford to live beyond their means through easy credit on terms that indicated repayment could only come by taking a larger loan to re-finance. Larger debt was not considered scary, as the availability of cheap credit brought an asset price bubble in real estate making the net finances of consumers appear stronger, higher debt notwithstanding, for as long as the value of their immoveable, mostly residences, kept increasing.
It also worked well for the surplus countries as it permitted them to peg their own currencies to the US dollar in order to protect their price competitiveness by not allowing their own currency to revalue in accordance with the efficiency gains and development of their own economy.
Reality can be avoided for a long time but not forever. Something had to give and it finally snapped on both sides of pacific, and also in Europe, with unpleasant consequences.
On the US side, the property bubble burst with very severe consequences on the US consumers, who are witnessing the value of their property fall below the level of covering mortgages, leading to loan defaults, foreclosure and a glut of unsold property stock that is continuing to depress property prices, sometimes to exaggerated levels. The pendulum never stops in the middle when it is released from far out. This is causing the banks to register huge losses on their property exposure, weakening bank balance sheets, demanding massive recapitalisations and causing severe illiquidity on the financial markets, where even the most deserving are finding it difficult to access credit.
On the Asia side, the fall in the value of the US dollar and the corresponding fall in their own pegged currencies is causing accelerating domestic inflation, overheating their economies with an increased risk of economic collapse and huge foreign exchange losses on their foreign reserves if the rate of exchange of their domestic currency has to be allowed to revalue to mitigate the serious problem of inflation.
On the European side, countries who had experienced a property boom caused by their recent economic successes, such as the UK, Ireland and Spain, are now being hit by the burst property bubble and illiquid financial markets imported from the US. Euro area countries are suffering from an overvalued currency that had to absorb the fall in the value of the US dollar, which should have been absorbed by the surplus Asian currencies that however remain artificially pegged to the US dollar.
Every country is suffering under the severe strain of exploding energy prices and exploding food prices, which was contributed to partly by the mistaken policy of trying to solve the energy crisis by shifting to bio-fuel production the resources normally allocated to food production.
We are now in the painful phase of re-balancing structural imbalances which suddenly became unsustainable. The US economy is slowing, flirting with outright recession at a time when consumers are being hit right, left and centre. Their asset values are falling, their purchasing power is being hit by the doubling of energy prices and they are suffering withdrawal symptoms from credit dependence as credit is no longer available. This slowdown will reduce consumer demand, which will address the balance of payment deficit through rising unemployment and business defaults. Asia will also have to slow down its pace of growth if it is to address its domestic inflation problem. Higher domestic interest will make the currencies of Japan, China, Korea, Taiwan and other Asian tigers unable to sustain their peg to the US$. In the absence of a drastic decision to allow their currencies to float freely, monetary authorities will have at least to tolerate greater flexibility in their peg to the US$. A contemporaneous slowdown in the US and Asia will go a long way to address structural imbalances but only at the expense of a rather prolonged, even if shallow, recession. Such curtailment of demand would then reduce the rise in the price of energy and commodities and sometime in 2009 we could possibly look forward to growth based on a more sustainable base.
There are many theories as to why we have come to this point and why it has happened so suddenly, when until this time last year the world seemed perfectly comfortable with long-standing structural imbalances. My explanation to this is what I term the curse of the reserve currency.
The moment a currency is accepted as an international reserve currency there is born within it the seeds of its own destruction. The owner of the reserve currency, as the US has been since the end of the Nazi war, has the facility to acquire its needs from the rest of the world merely by creating more of the freely acceptable currency. In reality, it becomes an obligation to service world growth by creating more of the reserve currency entailing the reserve currency-owning country to start running chronic balance of payments deficits. In simple layman’s language, this means that the owner of the reserve currency will be duped to start living well beyond its means.
Too much of a good thing gradually starts creating its own problems, as reserve currency holders start getting restless with the large accumulation of reserves and growing doubt about the sustainability of its value. Six years ago the US$ was worth €1.290. Now it is worth €0.58. Its value has more than halved in Euro terms. Could the increase in the price of energy and commodities be explained, at least in part, by the policy of mass holders of US$ to convert them into real assets as quickly as possible by buying energy and commodities both spot and futures before the dollar falls further?
We are possibly at the sunset stage of the US$ as a reserve currency after suffering the curse reserved for such status. What will take its place remains to be seen.
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